Trapped by Liquidity (Last Year Was Not An Anomaly)

For 2019, the key factors that we need to think about are what is going to be the outlook on three levels: monetary, macro, and earnings. Watch my entire interview at Real Vision here.

In general, considering where expectations are right now, we are still in a stealth downgrade mode, Industrial production, and ISMs are slowly descending from the high levels while rising global debt is also an important factor.

MONETARY policy

Monetary factors are also very important. If we look at the way in which most investors are positioned right now, the vast majority of us are expecting that the improvement for next year is going to come from central banks not doing what they have said that they will do, which, in general, is a pretty dangerous position to take.

However, even if they did ease, and I believe that they will definitely slow down the pace ofnormalization, we need to understand that the placebo effect of central bank policy on markets has stopped working as a tool to expand multiples and asset valuations. We have seen it in Japan and in Europe. Despite ongoing easing, it does not transfer into further multiple expansion and financial asset inflation. It only helps yields remain low. It only helps valuations remain where they are.

earnings

On earnings, the problem that I see continues to be in the next two years’ estimates because I continue to believe that those have not come down enough. You still see in consensus expectations double-digit EPS growth. That is very, very, very unlikely.

In an environment in which central banks continue to be accommodative, but macro and earnings are not supportive, cycles become very short. So we need to be a lot more active.

macro

The Chinese, Japanese and Eurozone slowdown are all happening in the middle of massive stimuli and deficit spending. We cannot fool ourselves and say that the markets and macro disappointments this year are due to trade wars or the normalization of the Federal Reserve. Those are subterfuges that we use to avoid reality. And the reality is debt saturation. More debt generates less growth and higher risk.

Central banks care a lot about asset prices. The Central Bank of Japan would not be buying equities if they didn’t care about asset prices. Buying equities has absolutely nothing to do with inflation or with unemployment or economic growth. It’s because they care about asset price inflation. However, the Federal Reserve finds itself in a position in which if they care only about asset prices, they don’t build enough tools into a change of cycle. And therefore, they might end up creating a larger problem than the temporary effect on markets. If they revert the policy, they will give a message to markets that they know something that we don’t know, and that that something is truly bad.

The ECB knows that there is no real demand for sovereign bonds at these yields, not even close. We would need to think of double the current levels of sovereign bond yields for marginal investors (not forced buyers) to think of purchasing eurozone sovereign bonds

The eurozone countries have saved themselves about 1 trillion euros in interest expenses. Not bad, but they’ve spent it all. And very few countries in the eurozone are ready for an increase of 10% or 20% of their borrowing costs.

The eurozone is unable to disguise through monetary policy its structural problems, aging of the population, overcapacity, low productivity growth, and at the same time, an extraordinarily high level of unemployment. Those factors are all added to an elevated debt and government spending.

The eurozone has convinced itself that the entire problem was the alleged austerity. There’s no austerity at 40% public spending to GDP. So the solution that they are looking at is further and higher government spending. And government spending is not going to drive productivity growth, improvement in the economy, and the structural changes that the eurozone desperately needs. It’s very likely that the eurozone continues to do what Japan did in the late ’80s. Spend its way to stagnation.

The US economy, with all of its challenges, is much more robust than the European economy. In the eurozone 80% of the real economy is financed by banks, so the contagion effect of financial woes is very high. In the US it is less than 40%. Throughout the years of QE in the United States, the Federal Reserve was never 100% of the demand for sovereign bonds in the market. So it always kept an eye on the secondary market. Even though it was influencing aggressively the yields of sovereign bonds, it is also true that there was always a secondary market moving around. That is not the case in the eurozone. In the eurozone, the European Central Bank is 100% of the demand for sovereign bonds for the majority of the net financing needs of the eurozone countries. As such, there is absolutely no way of understanding where will marginal investors want to buy Portuguese, Spanish or Italian bonds.

My concern is that the way in which governments and central banks are positioned right now, they have no tools to address a much deeper slowdown.

China is already caught in a liquidity trap. China has been posting weakening numbers quarter on quarter for more than two years. I think that China made a mistake when the policy of addressing the increasing debt and the so-called change of model from an industrially intensive to a consumer-driven model was stopped.

Consider this. If you have an economy that is growing at 6.5% healthily with low inflation and low unemployment you do not devalue your currency stealthily and implement a massive stimulus and liquidity injection. It does not add up. China will likely slow down in the middle of a massive stimulus because it has surpassed its debt saturation limit as well.

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